Many Happy Returns

By

Burton Malkiel

Updated May 28, 2007 12:01 am ET / Original Sept. 15, 2019 6:07 am ET

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WITH THE STANDARD & POOR'S 500 STOCK INDEX having turned 50 this year, critics argue there are far better stock-market benchmarks and instruments for index-fund portfolios. But I see the S&P as still going strong and very unlikely to be knocked off its perch as the preeminent index of choice for the core of an equity portfolio.

One common criticism of the S&P is that it is a "managed" index, with component stocks selected by committee. But objective criteria are used in the selection process, and the S&P is almost perfectly correlated with a capitalization-weighted index of the 500 largest companies in the U.S. As such, it represents 75% of the total capitalization of the U.S. stock market. Other critics argue that the S&P is too narrow, and that an indexed portfolio should track the market as a whole. There's no reason, they say, to exclude the approximately 25% of the market made up of smaller stocks.

Indeed, the empirical evidence indicates that returns from small-capitalization stocks have been higher than those from large-caps. In most cases, however, it is active management that produced small-caps' excess returns. Large-caps are more thoroughly researched by Wall Street analysts, leaving less opportunity for active investors. While indexing works well even in potentially less efficient markets, many pros index only a core portfolio of large-cap U.S. stocks, and use active management for small-caps.

Perhaps the most frequent criticism of the S&P is that it fails to correct for "bubbles" in market sectors. Technology stocks were overweighted in the index in late 1999 and early 2000, when they sold at exorbitant price-earnings multiples. At least in principle, active management could correct for such biases, though the evidence from the past 50 years strongly suggests that active managers have not been successful in avoiding overvalued sectors of the market.

Moreover, markets need not be efficient to justify an indexing strategy using capitalization weights. All the stocks in the market must be held by someone. Thus, investors as a group must own the capitalization-weighted index of all stocks. If some happen to hold only the best performers in their portfolios, others must be holding the poorer performer. Investing must be a zero-sum game.

In fact, active management is a negative-sum game. Active managers incur two types of costs: management fees and turnover costs. Mutual-fund management fees average about one percentage point a year. Turnover costs (commissions, bid-asked spreads, market-impact costs) easily add another half a percentage point. Passively managed index funds and exchange-traded funds now are available at less than a tenth of a percentage point, and have minimal turnover. Thus, the average active manager must underperform a low-cost index fund by the difference in fees.

In the past 10 and 20 years, the S&P 500 has outperformed more than 75% of actively managed large-cap equity funds. The amount of that outperformance after fees has been 1.4 percentage points annually. The S&P funds also have been more tax-efficient. While a few active funds have beaten the S&P over the long run, there is no way to predict the winners in advance. "Hot" funds in one period are often the worst performers in the next.

Recently a fourth criticism has been leveled against the S&P: Its weighting mechanism tends to overweight overvalued stocks. According to this argument (championed most prominently by Robert Arnott of Research Affiliates), stocks should be weighted by their economic footprint (the amount of their profits, book values and such) rather than their capitalization, or stock-market value. A fundamentally weighted index will tend to outperform a cap-weighted index, such critics say.

The Bottom Line

After 50 years, the S&P 500 has proved its worth as a benchmark for large-cap U.S. stocks. It's likely to remain the basis for index funds and ETFs for the next 50 years, as well.

To be sure, the
PowerShares FTSE RAFI US 1000
exchange-traded fund (ticker: PRF), which tracks Research Affiliates' RAFI 1000 index, has outperformed the S&P 500 since it was launched in December 2005. But the RAFI 1000 has a value and small-cap bias. This and similar fundamentally weighted indexes are active bets, and I doubt they will be consistent excess performers now that price-earnings multiples are compressed.

Nor are they "indexes" in the sense that all investors can own them. Consequently I believe the S&P 500 will continue to serve as the most useful large-cap benchmark and basis for popular index funds and ETFs for the next 50 years. Happy birthday -- and many happy returns.

BURTON MALKIEL is the Chemical Bank Chairman's Professor of Economics at Princeton University.

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